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Segment Reporting, Decentralization,

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					ACC 202 Intro to
Management Accounting
Chapter 12:
Segment Reporting, Decentralization, & Transfer Pricing

obj 1

Learning Objectives
a segmented income statement (contribution format)  Work with traceable fixed costs, common fixed costs, & segment margin  Derive a negotiated transfer price  Compute & understand ROI  Compute & understand residual income
 Prepare

Decentralization in Organizations
Benefits of Decentralization
Lower-level managers gain experience in decision-making. Lower-level decision often based on better information. Top management freed to concentrate on strategy.

Decision-making authority leads to job satisfaction.

Lower level managers can respond quickly to customers.

Decentralization in Organizations
May be a lack of coordination among autonomous managers.

Lower-level managers may make decisions without seeing the “big picture.” Lower-level manager’s objectives may not be those of the organization.

Disadvantages of Decentralization

May be difficult to spread innovative ideas in the organization.

Cost, Profit, & Investments Centers

Cost Center

Profit Center

Investment Center

Cost, profit, and investment centers are all known as responsibility centers.

Responsibility Center

Cost, Profit, & Investments Centers
Cost Center A segment whose manager has control over costs, but not over revenues or investment funds.

Cost, Profit, & Investments Centers
Profit Center A segment whose manager has control over both costs and revenues, but no control over investment funds.
Revenues
Sales

Interest
Other

Costs
Mfg. costs

Commissions
Salaries Other

Cost, Profit, & Investments Centers
Investment Center A segment whose manager has control over costs, revenues, and investments in operating assets.

Corporate Headquarters

Responsibility Centers
Investment Centers
O p e ratio ns V ic e P re sid e nt S u p e rio r F o o ds C o rp o ra tion C o rp o rate H e a dq u a rte rs P re s ide n t a nd C E O

F in an ce C h ie f F In a nc ia l O ffic er

L e g al G e n e ra l C ou n s el

P e rs on n el V ic e P re sid e nt

S a lty S na c ks P ro d u c t M a n g er

B e vera g es P ro d u c t M a n a g er

C o n fe c tio ns P ro d u c t M a n a g er

B o ttlin g P la nt M a na g er

W a reh o u se M a na g er

D is trib u tio n M a na g er

Cost Centers

Superior Foods Corporation provides an example of the various kinds of responsibility centers that exist in an organization.

Responsibility Centers
S u p e rio r F o o ds C o rp o ra tion C o rp o rate H e a dq u a rte rs P re s ide n t a nd C E O

O p e ratio ns V ic e P re sid e nt

F in an ce C h ie f F In a nc ia l O ffic er

L e g al G e n e ra l C ou n s el

P e rs on n el V ic e P re sid e nt

S a lty S na c ks P ro d u c t M a n g er

B e vera g es P ro d u c t M a n a g er

C o n fe c tio ns P ro d u c t M a n a g er

B o ttlin g P la nt M a na g er

W a reh o u se M a na g er

D is trib u tio n M a na g er

Profit Centers

Superior Foods Corporation provides an example of the various kinds of responsibility centers that exist in an organization.

Responsibility Centers
S u p e rio r F o o ds C o rp o ra tion C o rp o rate H e a dq u a rte rs P re s ide n t a nd C E O

O p e ratio ns V ic e P re sid e nt

F in an ce C h ie f F In a nc ia l O ffic er

L e g al G e n e ra l C ou n s el

P e rs on n el V ic e P re sid e nt

S a lty S na c ks P ro d u c t M a n g er

B e vera g es P ro d u c t M a n a g er

C o n fe c tio ns P ro d u c t M a n a g er

B o ttlin g P la nt M a na g er

W a reh o u se M a na g er

D is trib u tio n M a na g er

Cost Centers

Superior Foods Corporation provides an example of the various kinds of responsibility centers that exist in an organization.

Decentralization & Segment Reporting
A segment is any part or activity of an organization about which a manager seeks cost, revenue, or profit data. A segment can be . . .
An Individual Store
Quick Mart

A Sales Territory

A Service Center

Superior Foods: Geographic Regions
S u p e rio r F o o ds C o rp o ra tion $ 50 0,0 00 ,0 00

E a st $ 75 ,000 ,000

W e st $ 30 0,0 00 ,0 00

M id w e st $ 55 ,000 ,000

S o u th $ 70 ,000 ,000

O re g on $ 45 ,000 ,000

W a s h in g ton $ 50 ,000 ,000

C a lifo rn ia $ 12 0,0 00 ,0 00

M o u n ta in S ta tes $ 85 ,000 ,000

Superior Foods Corporation could segment its business by geographic regions.

Superior Foods: Customer Channel
S u p e rio r F o o ds C o rp o ra tion $ 50 0,0 00 ,0 00 C o n ven ie n c e S to res $ 80 ,000 ,000 S u p e rm a rk e t C h a ins $ 28 0,0 00 ,0 00 W h o les a le D is trib u to rs $ 10 0,0 00 ,0 00 D ru g s to res $ 40 ,000 ,000

S u p e rm a rk e t C h a in A $ 85 ,000 ,000

S u p e rm a rk e t C h a in B $ 65 ,000 ,000

S u p e rm a rk e t C h a in C $ 90 ,000 ,000

S u p e rm a rk e t C h a in D $ 40 ,000 ,000

Superior Foods Corporation could segment its business by customer channel.

Segmented Income Statements
Two keys to building segmented income statements:
A contribution format should be used because it separates fixed from variable costs and it enables the calculation of a contribution margin. Traceable fixed costs should be separated from common fixed costs to enable the calculation of a segment margin.

Identifying Traceable Fixed Costs
Traceable costs arise because of the existence of a particular segment and would disappear over time if the segment itself disappeared. No computer division means . . . No computer division manager.

Identifying Common Fixed Costs
Common costs arise because of the overall operation of the company and would not disappear if any particular segment were eliminated. No computer division but . . . We still have a company president.

Traceable Costs Can Become Common Costs
It is important to realize that the traceable fixed costs of one segment may be a common fixed cost of another segment. For example, the landing fee paid to land an airplane at an airport is traceable to the particular flight, but it is not traceable to first-class, business-class, and economy-class passengers.

Segment Margin
segment margin is the best gauge of the long-run profitability of a segment.  Segment margin = contribution margin – traceable fixed costs.
Profits
 The

Time

Traceable and Common Costs
Fixed Costs Don’t allocate common costs to segments. Common

Traceable

Levels of Segmented Statements
Webber, Inc. has two divisions.
W e b b e r, In c .

C o m p u te r D ivisio n

T e le visio n D ivisio n

Let’s look more closely at the Television Division’s income statement.

Levels of Segmented Statements
Our approach to segment reporting uses the contribution format.
Income Statement Contribution Margin Format Television Division Sales $ 300,000 Variable COGS 120,000 Other variable costs 30,000 Total variable costs 150,000 Contribution margin 150,000 Traceable fixed costs 90,000 Division margin $ 60,000

Cost of goods sold consists of variable manufacturing costs. Fixed and variable costs are listed in separate sections.

Levels of Segmented Statements
Our approach to segment reporting uses the contribution format.
Income Statement Contribution Margin Format Television Division Sales $ 300,000 Variable COGS 120,000 Other variable costs 30,000 Total variable costs 150,000 Contribution margin 150,000 Traceable fixed costs 90,000 Division margin $ 60,000

Contribution margin is computed by taking sales minus variable costs. Segment margin is Television’s contribution to profits.

Levels of Segmented Statements
Income Statement Company Television $ 500,000 $ 300,000 230,000 150,000 270,000 150,000 170,000 90,000 100,000 $ 60,000 Computer $ 200,000 80,000 120,000 80,000 $ 40,000

Sales Variable costs CM Traceable FC Division margin Common costs Net operating income

Levels of Segmented Statements
Income Statement Company Television Computer $ 500,000 $ 300,000 $ 200,000 230,000 150,000 80,000 270,000 150,000 120,000 170,000 90,000 80,000 100,000 $ 60,000 $ 40,000 25,000 Common costs should not $ 75,000

Sales Variable costs CM Traceable FC Division margin Common costs Net operating income

be allocated to the divisions. These costs would remain even if one of the divisions were eliminated.

Traceable Costs Can Become Common Costs
As previously mentioned, fixed costs that are traceable to one segment can become common if the company is divided into smaller segments.
Let’s see how this works using the Webber Inc. example.

Traceable Costs Can Become Common Costs
Webber’s Television Division
Television Division

Regular

Big Screen

Product Lines

Traceable Costs Can Become Common Costs
Income Statement Television Division Regular Sales $ 200,000 Variable costs 95,000 CM 105,000 Traceable FC 45,000 Product line margin $ 60,000 Common costs Divisional margin Big Screen $ 100,000 55,000 45,000 35,000 $ 10,000

We obtained the following information from the Regular and Big Screen segments.

Traceable Costs Can Become Common Costs
Income Statement Television Division Regular Sales $ 300,000 $ 200,000 Variable costs 150,000 95,000 CM 150,000 105,000 Traceable FC 80,000 45,000 Product line margin 70,000 $ 60,000 Common costs 10,000 Divisional margin $ 60,000 Big Screen $ 100,000 55,000 45,000 35,000 $ 10,000

Fixed costs directly traced to the Television Division
$80,000 + $10,000 = $90,000

External Reports
The Financial Accounting Standards Board now requires that companies in the United States include segmented financial data in their annual reports.
1. Companies must report segmented results to shareholders using the same methods that are used for internal segmented reports. Since the contribution approach to segment reporting does not comply with GAAP, it is likely that some managers will choose to construct their segmented financial statements using the absorption approach to comply with GAAP.

2.

Omission of Costs
Costs assigned to a segment should include all costs attributable to that segment from the company’s entire value chain.
Business Functions Making Up The Value Chain
R&D

Product Design

Customer Manufacturing Marketing Distribution Service

Inappropriate Methods of Allocating Costs Among Segments
Failure to trace costs directly Inappropriate allocation base

Segment 1

Segment 2

Segment 3

Segment 4

Common Costs and Segments
Common costs should not be arbitrarily allocated to segments based on the rationale that “someone has to cover the common costs” for two reasons:

1. This practice may make a profitable business segment appear to be unprofitable.
2. Allocating common fixed costs forces managers to be held accountable for costs they cannot control.

Segment 1

Segment 2

Segment 3

Segment 4

Allocations of Common Costs
Income Statement Haglund's Lakeshore Bar $ 800,000 $ 100,000 310,000 60,000 490,000 40,000 246,000 26,000 244,000 $ 14,000 200,000 $ 44,000 Restaurant $ 700,000 250,000 450,000 220,000 $ 230,000

Sales Variable costs CM Traceable FC Segment margin Common costs Profit

Assume that Haglund’s Lakeshore prepared the segmented income statement as shown.

Quick Check 
How much of the common fixed cost of $200,000 can be avoided by eliminating the bar? a. None of it. b. Some of it. c. All of it.

Quick Check 
Suppose square feet is used as the basis for allocating the common fixed cost of $200,000. How much would be allocated to the bar if the bar occupies 1,000 square feet and the restaurant 9,000 square feet? a. $20,000 b. $30,000 c. $40,000 d. $50,000

Quick Check 
If Haglund’s allocates its common costs to the bar and the restaurant, what would be the reported profit of each segment?

Allocations of Common Costs
Income Statement Haglund's Lakeshore Bar $ 800,000 $ 100,000 310,000 60,000 490,000 40,000 246,000 26,000 244,000 14,000 200,000 20,000 $ 44,000 $ (6,000) Restaurant $ 700,000 250,000 450,000 220,000 230,000 180,000 $ 50,000

Sales Variable costs CM Traceable FC Segment margin Common costs Profit

Now all costs are allocated.

Quick Check 
Should the bar be eliminated? a. Yes b. No

Transfer Pricing Concepts
A transfer price is the price charged when one segment of a company provides goods or services to another segment of the company.

The fundamental objective in setting transfer prices is to motivate managers to act in the best interests of the overall company.

Setting Transfer Prices
Three approaches to setting transfer prices: 1. Negotiated transfer prices 2. Transfers at the cost to the selling division 3. Transfers at market price

Negotiated Transfer Prices
A negotiated transfer price results from discussions between the selling and buying divisions.
Range of Acceptable Transfer Prices
Upper limit is determined by the buying division.

Advantages of negotiated transfer prices: 1. They preserve the autonomy of the divisions, which is consistent with the spirit of decentralization. The managers negotiating the transfer price are likely to have much better information about the potential costs and benefits of the transfer than others in the company.

2.

Lower limit is determined by the selling division.

Harris and Louder – An Example
Imperial Beverages and Pizza Maven are both owned by Harris and Louder.
Imperial Beverages: Ginger beer production capactiy per month Variable cost per barrel of ginger beer Fixed costs per month Selling price of Imperial Beverages ginger beer on the outside market Pizza Maven: Purchase price of regular brand of ginger beer Monthly comsumption of ginger beer

10,000 barrels £8 per barrel £70,000 £20 per barrel £18 per barrel 2,000 barrels

Harris and Louder – An Example
The selling division’s (Imperial Beverages) lowest acceptable transfer price is calculated as:
Transfer Price  Variable cost Total contribution margin on lost sales + per unit Number of units transferred

Calculate the lowest and highest acceptable transfer prices under three scenarios.
The buying division’s (Pizza Maven) highest acceptable transfer price is calculated as:

Transfer Price  Cost of buying from outside supplier
If an outside supplier does not exist, the highest acceptable transfer price is calculated as:
Transfer Price  Profit to be earned per unit sold (not including the transfer price)

Harris and Louder – An Example
If Imperial Beverages has sufficient idle capacity (3,000 barrels) to satisfy Pizza Maven’s demands (2,000 barrels) without sacrificing sales to other customers, then : Selling division’s lowest possible transfer price:

Transfer Price  Variable Costs = £8
Buying division’s highest transfer price:

Transfer Price  Cost of buying from outside supplier

= £18

Therefore, the range of acceptable transfer price is £8 – £18.

Harris and Louder – An Example
If Imperial Beverages has no idle capacity (0 barrels) and must sacrifice other customer orders (2,000 barrels) to meet Pizza Maven’s demands (2,000 barrels), then : Selling division’s lowest transfer price:
Transfer Price  Outside Selling Price = £20

Buying division’s highest transfer price:

Transfer Price  Cost of buying from outside supplier

= £18

Therefore, there is no range of acceptable transfer prices.

Harris and Louder – An Example
If Imperial Beverages has some idle capacity (1,000 barrels) and must sacrifice other customer orders (1,000 barrels) to meet Pizza Maven’s demands (2,000 barrels), then :

Selling division’s lowest transfer price: Transfer Price  ((1K x $8) + (1K x $20)) / 2K = £14

Buying division’s highest transfer price:

Transfer Price  Cost of buying from outside supplier

= £18

Therefore, the range of acceptable transfer price is £14 – £18.

Evaluation of Negotiated Transfer Prices
If a transfer within a company would result in higher overall profits for the company, there is always a range of transfer prices within which both the selling and buying divisions would have higher profits if they agree to the transfer.

If managers are pitted against each other rather than against their past performance or reasonable benchmarks, a noncooperative atmosphere is almost guaranteed.

Given the disputes that often accompany the negotiation process, most companies rely on some other means of setting transfer prices.

Transfers at the Cost to the Selling Division
Many companies set transfer prices at either the variable cost or full (absorption) cost incurred by the selling division.
Drawbacks of this approach include: 1. Using full cost as a transfer price and can lead to suboptimization. 2. The selling division will never show a profit on any internal transfer.

3. Cost-based transfer prices do not provide incentives to control costs.

Transfers at Market Price
A market price (i.e., the price charged for an item on the open market) is often regarded as the best approach to the transfer pricing problem.
1. A market price approach works best when the product or service is sold in its present form to outside customers and the selling division has no idle capacity. 2. A market price approach does not work well when the selling division has idle capacity.

Divisional Autonomy & Suboptimization
The principles of decentralization suggest that companies should grant managers autonomy to set transfer prices and to decide whether to sell internally or externally, even is this may occasionally result in suboptimal decisions. This way top management allows subordinates to control their own destiny.

International Aspects of Transfer Pricing
Transfer Pricing Objectives

Domestic
• Greater divisional autonomy • Greater motivation for managers • Better performance evaluation • Better goal congruence

International
• Less taxes, duties, and tariffs • Less foreign exchange risks • Better competitive position • Better governmental relations

Class Practice

Return on Investment (ROI)
Income before interest and taxes (EBIT)

Net operating income ROI = Average operating assets

Cash, accounts receivable, inventory, plant and equipment, and other productive assets.

Net Book Value vs. Gross Cost
Most companies use the net book value of depreciable assets to calculate average operating assets.

Acquisition cost Less: Accumulated depreciation Net book value

Return on Investment (ROI)
Net operating income ROI = Average operating assets

Net operating income Margin = Sales
Sales Turnover = Average operating assets ROI = Margin  Turnover

Increasing ROI
Three ways to increase ROI.
Increase Sales

Reduce Expenses
Reduce Assets

Increasing ROI – An Example
Regal Company reports the following: Net operating income Average operating assets Sales Operating expenses $ 30,000 $ 200,000 $ 500,000 $ 470,000

What is Regal Company’s ROI?

ROI = Margin  Turnover
ROI =
Net operating income Sales

×

Sales Average operating assets

Increasing ROI – An Example
ROI = Margin  Turnover
ROI =
Net operating income Sales

×

Sales Average operating assets

$30,000 ROI = $500,000

×

$500,000 $200,000

ROI = 6%  2.5 = 15%

Increasing Sales Without Increasing Operating Assets
manager was able to increase sales to $600,000 while operating expenses increased to $558,000.  Regal’s net operating income increased to $42,000 (600K – 558K).  There was no change in the average operating assets of the segment.
 Regal’s

Calculate the new ROI.

Increasing Sales Without Increasing Operating Assets
ROI = Margin  Turnover
ROI =
Net operating income Sales

×

Sales Average operating assets

ROI = $42,000 $600,000

×

$600,000 $200,000

ROI = 7%  3.0 = 21% ROI increased from 15% to 21%.

Decreasing Operating Expenses Without Changing Sales or Operating Assets
Assume that Regal’s manager was able to reduce operating expenses by $10,000 without affecting sales or operating assets. This would increase net operating income to $40,000.

Regal Company reports the following:
Net operating income Average operating assets Sales Operating expenses $ 40,000 $ 200,000 $ 500,000 $ 460,000

Calculate the new ROI.

Decreasing Operating Expenses Without Changing Sales or Operating Assets ROI = Margin  Turnover
ROI =
Net operating income Sales

×

Sales Average operating assets

ROI = $40,000 $500,000

×

$500,000 $200,000

ROI = 8%  2.5 = 20% ROI increased from 15% to 20%.

Decreasing Operating Assets Without Changing Sales or Operating Expenses
Assume that Regal’s manager was able to reduce inventories by $20,000 using just-in-time techniques without affecting sales or operating expenses.

Regal Company reports the following:
Net operating income Average operating assets Sales Operating expenses $ 30,000 $ 180,000 $ 500,000 $ 470,000

Calculate the new ROI.

Decreasing Operating Assets Without Changing Sales or Operating Expenses ROI = Margin  Turnover
ROI =
Net operating income Sales

×

Sales Average operating assets

ROI = $30,000 $500,000

×

$500,000 $180,000

ROI = 6%  2.77 = 16.7% ROI increased from 15% to 16.7%.

Investing in Operating Assets to Increase Sales
Assume that Regal’s manager invests in a $30,000 piece of equipment that increases sales by $35,000 while increasing operating expenses by $15,000.

Regal Company reports the following:
Net operating income Average operating assets Sales Operating expenses $ 50,000 $ 230,000 $ 535,000 $ 485,000

Calculate the new ROI.

Investing in Operating Assets to Increase Sales
ROI = Margin  Turnover
ROI =
Net operating income Sales

×

Sales Average operating assets

ROI = $50,000 $535,000

×

$535,000 $230,000

ROI = 9.35%  2.33 = 21.8% ROI increased from 15% to 21.8%.

ROI & the Balanced Scorecard
It may not be obvious to managers how to increase sales, decrease costs, and decrease investments in a way that is consistent with the company’s strategy. A well constructed balanced scorecard can provide managers with a road map that indicates how the company intends to increase ROI.

Which internal business process should be improved?

Which customers should be targeted and how will they be attracted and retained at a profit?

Criticisms of ROI
In the absence of the balanced scorecard, management may not know how to increase ROI. Managers often inherit many committed costs over which they have no control.
Managers evaluated on ROI may reject profitable investment opportunities.

Residual Income - Another Measure of Performance
Net operating income above some minimum return on operating assets

Calculating Residual Income
Residual = income Net operating income

(

Average operating assets



Minimum required rate of return

)

ROI measures net operating income earned relative to the investment in average operating assets. Residual income measures net operating income earned less the minimum required return on average operating assets.

Residual Income – An Example
 The

Retail Division of Zepher, Inc. has average operating assets of $100,000 and is required to earn a return of 20% on these assets.  In the current period the division earns net operating income of $30,000.

Calculate residual income.

Residual Income – An Example
Operating assets $ 100,000 Required rate of return × 20% Minimum required return $ 20,000

Actual income Minimum required return Residual income

$ 30,000 (20,000) $ 10,000

Motivation and Residual Income
Residual income encourages managers to make profitable investments that would be rejected by managers using ROI.

Quick Check 
Redmond Awnings, a division of Wrapup Corp., has a net operating income of $60,000 and average operating assets of $300,000. The required rate of return for the company is 15%. What is the division’s ROI? a. 25% b. 5% c. 15% d. 20%

Quick Check 
Redmond Awnings, a division of Wrapup Corp., has a net operating income of $60,000 and average operating assets of $300,000. If the manager of the division is evaluated based on ROI, will she want to make an investment of $100,000 that would generate additional net operating income of $18,000 per year? a. Yes b. No

Quick Check 
The company’s required rate of return is 15%. Would the company want the manager of the Redmond Awnings division to make an investment of $100,000 that would generate additional net operating income of $18,000 per year? a. Yes b. No

Divisional Comparisons and Residual Income
The residual income approach has one major disadvantage. It cannot be used to compare performance of divisions of different sizes.

Zepher, Inc. - Continued
Recall the following information for the Retail Division of Zepher, Inc. Assume the following information for the Wholesale Division of Zepher, Inc.

Retail Wholesale Operating assets $ 100,000 $ 1,000,000 Required rate of return × 20% 20% Minimum required return $ 20,000 $ 200,000 Retail Wholesale Actual income $ 30,000 $ 220,000 Minimum required return (20,000) (200,000) Residual income $ 10,000 $ 20,000

Zepher, Inc. - Continued
The residual income numbers suggest that the Wholesale Division outperformed the Retail Division because its residual income is $10,000 higher. However, the Retail Division earned an ROI of 30% compared to an ROI of 22% for the Wholesale Division. The Wholesale Division’s residual income is larger than the Retail Division simply because it is a bigger division.

Retail Wholesale Operating assets $ 100,000 $ 1,000,000 Required rate of return × 20% 20% Minimum required return $ 20,000 $ 200,000 Retail Wholesale Actual income $ 30,000 $ 220,000 Minimum required return (20,000) (200,000) Residual income $ 10,000 $ 20,000

Class Practice


				
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